Insure all of the mortgage credit risk in the us or

insure all of the mortgage credit risk in the US, or even all of the tail risk, would lead to an even bigger catastrophe than the one we just had. The only option appears to be the development, and most likely a slow one, of a private sector mortgage lending market for nonconforming mortgages. This market in theory would consider and price in the loan’s LTV, FICO score, the borrower’s income to mortgage interest ratio, as well as intangible information. Like other countries, it may well be that this market is not securitized, and loans would be held on the balance sheet of financial institutions as whole loans. It may be, however, that simpler, more standardized structured finance products develop and at least some of these loans would therefore be packaged and sold off as MBS to the capital markets at large. In any event, if financial firms hold onto these loans, or purchase the MBS in the secondary market, these firms will need to be well-capitalized and systemically less risky than other firms. It is pie in the sky, however, to believe that systemic risk will not exist in the mortgage finance market and that financial institutions will not gradually build up this risk on their

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122 balance sheets. It is unavoidable. As a result, it is crucial that the external costs of systemic risk are internalized by each financial institution; otherwise, these institutions will have the incentive to take risks that are not borne just by the institution but instead by society as a whole. This means that systemically important financial firms that are active in holding nonconforming mortgages as whole loans or as MBS should be charged either higher capital requirements, concentration limits, or a systemic risk “tax” in order to prevent them from accumulating too much systemic risk.60Consider the most likely remedy: higher capital requirements. Whatever capital requirements are placed on one set of financial institutions – say banks and bank holding companies - it is important that the financing of riskier mortgages does not just move elsewhere in the shadow banking system.61Yale economist John Geanakoplos has argued that it is not possible to solve this problem at the institutional level – measuring leverage and then implementing capital requirements fairly across financial firms. He argues instead that leverage should be legislated at the security level. This idea is tantamount to requiring a significant down payment or even banning nonconforming mortgages. We believe that an innovative way around this problem is that systemically risky firms could hold nonconforming mortgages but simultaneously would have to hold a position offsetting this risk -- a so called “macro hedge”. It would work as follows: For each dollar of nonconforming mortgage on the balance sheet, the firm would have a short position in an index of similarly risky MBS.

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